Ratios in Accounting

Accounting ratios are a representation of one value relative to another giving a broader picture of an increasing or decreasing trend of business in an organization. Values taken from the financial statements are shown either in the form of decimal or percentage for simplified study of the performance of an entity, appreciate it, compare it and use it for planning the future of the business. Mangers use these ratios to analyze the strengths and weaknesses of the firm and make important decisions like expanding the business or acquiring other firms after evaluating the financial position of the firm. The business owners and the shareholder get a true summary of the performance of the organization and its net worth in the market. These values are also important for the creditors to analyze, before approving the loan. Ratios expressed as decimal are generally for values more than 1, for example earning yield, while those expressed as percentage are for values smaller than1, for example P/E ratio.

These values are however not absolute and an end figure, but has to be supplemented with other information. Financial statements on one hand are the source of data for these ratios but on the other hand a limitation as well. The ratio has to be studied in the light of a historical record or current record available from other sources, working on the same model. For example a P/E ratio is just a number and would not make sense to the decision makers in an organization unless they compare it with the previous accounting period or against another organization in the same field. The ratios have to define according to the standards set by GAAP or IFRS depending on the extension of the business at national or international level respectively. Also the changing values with respect to time, e.g. price, have to be kept into consideration while referring the ratios.

The ratios are calculated from the following financial statements, based on the methods and standards as defined in accounting.

• Balance sheet

• Income statement

• Statement of cash flows

• Statement of retained earning